Taxation of Mutual Funds Long-Term Capital Gains

Team AckoDec 21, 2023

Mutual funds, today, are one of the most popular investment avenues for investors seeking sustainable growth. Benefits like risk diversification, affordability, tax benefits, great returns and more encourage people to invest in mutual funds. However, like other investments, mutual funds also have tax implications. Typically, profits earned from mutual funds are subject to tax as "Capital Gains", which can be long-term and short-term. The blog will discuss the intricacies of long-term capital gains (LTCG) and its tax implications on mutual funds.

Contents

• Understanding Mutual Funds and Its Types
• Tax Calculation of Long-Term Capital Gains on MFs
  • For Equity Funds
  • For Debt Funds
  • For Equity-Oriented Hybrid Funds
  • For Debt-Oriented Balanced Funds
  • For Unlisted Equity Funds
• Taxation of Mutual Funds Long-Term Capital Gains
• Significance of Mutual Funds Long-Term Capital Gains Taxation 
• Tax Exemptions on Mutual Funds Long-Term Capital Gains
  • Under Section 10(38)
  • Under Section 54F
• Fun Facts About Taxation on Mutual Funds
• In a Nutshell
• Frequently Asked Questions

Understanding Mutual Funds and Its Types

Mutual funds (MFs) are a valuable investment that collects and pools funds from various investors, which are invested in equities, bonds, securities and other money market instruments. The entire process is managed by professional funds managers, who invest your funds based on the fund's objectives and market conditions. The performance of MFs is calculated through its Net Asset Value (NAV), which is the total value of the fund's assets after deducting applicable expenses and levies. Some popular types of MF include:

• Equity Funds

• Debt Funds

• Hybrid Funds

• Money Market Funds

• Index Funds

• Specialty Funds

• Sectoral Funds

Tax Calculation of Long-Term Capital Gains on MFs

LTCG refers to an investor's profits from selling stocks or redeeming their MF units. If the investment has been held for over a year in equity funds, the gains will be known as long-term capital gains. In simple terms, LTCG is calculated by deducting the purchase cost from the price at which your MFs or stocks are sold. 

For Equity Funds

After April 1st 2018, a 10% tax (without indexation) along with a surcharge, health and education cess applies on LTCG if your overall equity funds capital gains exceed Rs 1 Lakh when selling or redeeming MF units. It means if you held your MF for over one year and earned Rs 2 Lakh profits, the taxable LTCG will be Rs 1 Lakh.

(Rs 2 Lakh - Rs 1 Lakh) + 10% Tax = Rs 10,000

For Debt Funds

These MFs are debt instruments purchased from the market, and the investors need to bear the LTCG tax of 20% (after indexation). The calculation of indexation is done through the Cost Inflation Rate, considering inflation in the cost of acquisition. It helps to reduce the capital gain amount. Indexation techniques allow investors to adjust the purchase price of the MF units to reflect inflation. Here is how it is calculated:

(Actual Cost of Acquisition x Index of the Current Year)/Index of the base year. 

For Equity-Oriented Hybrid Funds

These MFs help investors buy debt and equity funds. In hybrid funds, investors must make 65% of the investments towards equity or equity-oriented shares. Therefore, the LTCG tax follows a similar regime as equity funds. 

For Debt-Oriented Balanced Funds

These MFs allow investors to reinvest 60% of total funds towards debt instruments. Therefore, the LTCG tax follows a similar regime as debt funds, which is 20% after indexation. 

For Unlisted Equity Funds

Unlisted equity funds are shares and stocks available over the counter and are not listed on the stock exchanges. The long-term capital gains from unlisted equity funds will have a 20% tax and the benefit of indexation. Also, the tax rate in these funds has surcharges and cess tax.

Note: You will only bear taxes on MF investments when you sell or redeem the unit. Hence, the capital gains tax on MFs is not applicable yearly. 

Taxation of Mutual Funds Long-Term Capital Gains

Here are the tax implications on long-term capital gains based on fun type.

Significance of Mutual Funds Long-Term Capital Gains Taxation 

As an investor of mutual funds, you must understand how LTCG taxation works. Here are some reasons: 

• Tax Planning: By understanding the taxation of mutual funds long-term capital gains, you can strategically redeem your investments to optimise your tax liability.  
   

• Investment Horizon: You will learn which funds you need to hold on to for longer to benefit from the LTCG rules. It will help with your plan for the long-term investment horizon of MF. 
   

• Selecting Funds: You can choose better between equity and debt funds. For instance, if you fall under a higher tax slab, you might prefer the tax treatment of LTCG on equity funds over the interest income from debt funds. 

Tax Exemptions on Mutual Funds Long-Term Capital Gains

You can enjoy tax exemption under section 10(38) and section 54F on mutual funds LTCG:

Under Section 10(38)

According to section 10(38) of the Income Tax Act 1961, the LTCG arising after the transfer of equity or equity-oriented shares is eligible to be free from taxes under the following circumstances: 

• The transfer was done on or after October 1st 2004

• The transferred asset is of long-term

• The sale transaction falls under security transaction tax

Under Section 54F

According to section 54F of the Income Tax Act 1961, investors can enjoy tax exemption on the LTCG earned from selling any capital asset under the following circumstances:

• You have purchased the asset one year before or after two years from the sale date. 

• You have constructed a property with your capital gains from sales, completed within three years from the transaction date. 

Apart from exemptions provided under the Income Tax Act 1961, strategies like "tax harvesting" can be helpful when planning tax savings. However, such strategies require careful planning and a hands-on understanding of the investment process. 

Fun Facts About Taxation on Mutual Funds

• You do not pay dividend distribution tax on equity funds

• MFs are not considered wealth; hence, no wealth tax applies to them

• LTCG are taxed at a lower rate than short-term capital gains

In a Nutshell

Investing in mutual funds is an effective investment in the capital market. It offers diversification, liquidity, professional management and more. Understanding the nuances of LTCG can help you make informed decisions to optimise your returns and reduce tax liabilities.

However, like all investments, mutual funds have risks, making it crucial to understand every detail before investing. Consulting a financial advisor or tax consultant can help you better understand taxation's impact on mutual funds' long-term capital gains.

Frequently Asked Questions

Here are some common questions on the taxation of mutual funds long-term capital gains.

Are mutual funds tax-free?

No, mutual funds are not universally tax-free. However, by investing in an ELSS equity-linked saving scheme, you can claim a tax exemption of up to Rs 1.5 lakh under section 80C of the Income Tax Act 1961.   

How can I avoid capital gains taxation on my mutual funds?

Yes, you must invest in equity funds and stay invested for over a year. In such cases, long-term capital gains will be applicable, which are exempted up to 1 Lakh under equity funds. 

Are mutual funds considered capital gains?

Yes, typically, mutual funds are your capital assets. Hence, capital gains and the following tax will be applicable. The tax rate will, however, vary based on the holding period and the type of mutual funds. 

Under which section does LTCG on mutual funds get exempted?

You can enjoy tax exemption under section 10(38) and section 54F of the Income Tax Act 1961 on mutual funds LTCG.

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